Two Federal Reserve officials on Friday painted divergent pictures of U.S. economic strength, suggesting a growing split at the central bank that could affect the outlook for interest rates.

Philadelphia Fed President Charles Plosser and Minneapolis Fed President Narayana Kocherlakota both said the U.S. economic recovery is underway and inflation remains subdued.

But while Plosser suggested the U.S. could handle a gradual withdrawal of some of the extraordinary support the Fed has given the economy, Kocherlakota voiced concern over the drag that a weak banking sector exerts on jobs growth and recovery overall through constraints on lending.

The Fed cut benchmark interest rates to the bone in December 2008 and bought more than $1.4 trillion of mortgage-related debt to support an economy that was reeling from the worst financial crisis since the Great Depression.

The U.S. central bank should start selling some of these assets sooner rather than later to avoid sowing the seeds of future inflation, Plosser said.

Despite recent volatility in markets due to fiscal deficit problems in Europe, financial markets are now functioning much better than they were during the height of the financial crisis, Plosser said in remarks to the Blair County Chamber of Commerce in Altoona, Pa.

I believe the Fed could begin to liquidate its positions gradually without market disruption.

Speaking to reporters after his speech, Plosser said he didn't think the time was today for asset sales. He said the decision of when to sell assets would depend on economic conditions.

In his speech, the Philadelphia Fed chief said U.S. economic recovery appears to be sustainable, with stronger business spending and moderate consumer spending growth.

He said he expects inflation to remain subdued in the near term, but warned that as the economic recovery takes hold the Fed must ensure price pressures stay under wraps.

In addition to buying mortgage-related debt, the Fed also cut benchmark interest rates to the bone to support an economy that was reeling from the worst financial crisis since the Great Depression.

The central bank has kept its target for the benchmark federal funds rate at near zero since December 2008 and has pledged to keep it there for an extended period.

If we do not exit from this strategy in a timely manner, we could be sowing the seeds of another round of uncomfortable and costly inflation in the intermediate term, he said.

Returning to a more normal monetary policy will involve ... returning to an all-Treasuries portfolio, and raising the short-term interest rate toward a more normal level, he said.

Plosser said even if the benchmark interest rate target was increased to 1 percent, policy would remain very accommodative.

But he did not go as far as his counterpart at the Kansas City Fed, Thomas Hoenig, who earlier this month made a bold call for the benchmark interest rate to be raised to 1 percent by the end of the summer.

Plosser told reporters he didn't want to put a time-frame on rate increases, arguing that this was a reason he was uncomfortable with the Fed's pledge to keep rates low for an extended period.

Some people perceive that language implies calendar time, and that can be misleading, Plosser said.

Like Hoenig, Plosser is known as one of the more hawkish regional Fed presidents on inflation. He is not a voting member of the Fed's policy-setting committee this year.

Kocherlakota, who also is not a voting member of the policy-setting Federal Open Market Committee this year, is the newest regional Fed bank president - he started his job last October - and his policy leanings are not yet entirely clear.

He did not directly address monetary policy in his speech.

But he tempered his outlook for 3.5 percent GDP growth over the next two years with a note of caution over the high jobless rate.

With unemployment at 9.7 percent, he said, I am concerned about the ongoing lack of vitality in the American labor market.

Very subdued lending is contributing to the slow growth in jobs, and banking sector weakness is likely to continue for the next year or two, he said, making it unlikely that the jobless rate will fall below 8 percent even by the end of next year.

Plosser reiterated that the Fed will have to begin tightening monetary policy well before the jobless rate has fallen to acceptable levels. The unemployment rate will decline only gradually, he said.

Plosser described the U.S. jobs report last Friday, which showed just 41,000 private sector jobs were created in May, as somewhat disappointing but cautioned not to read too much into one month's data.

Economic news released on Friday seemed to echo the gap in Fed officials' outlook for the U.S. economy, with retail sales in May posting the first decline since September, and consumer sentiment registering at its highest level since January 2008.

(Editing by Theodore d'Afflisio)

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